What Is and What Shall Be

It is our view that, as long as inflation remains tame, the Fed will keep rate policy accommodative, regardless of what the market views as encouraging employment trends. The Fed does not want to hear employment conditions are improving. The Fed wants to see employment conditions are improving. This means, not only must the unemployment rate decline, labor force participation will have to stabilize and there have to be signs that wage growth is improving due to an increased demand for workers. It is our view that the Fed Funds Rate will remain at or near zero throughout 2014 and, probably, throughout much of 2015. It is also our view that the 10-year Treasury yield will probably not touch 4.00% this year. In fact, it might be a while before we break 3.00% (probably not before the next round of jobs data, at least).

The uneven and inconsistent economic expansion has flummoxed economists, market participants and investors. Last year, the sequester-related spending cuts were expected to stagger the U.S. economy. However, the economy was unexpectedly resilient. This led many market participants to believe that the economy was close to structural health. However, wage growth remained stagnant and, with the exception of October and November of last year, hiring was lackluster. Retail sales data from the holidays indicate somewhat better spending, but many retailers had to significantly compromise profitability to boost sales. We believe that the resiliency of the economy is mostly about prices.

Price cuts and incentives offered to consumers during the holiday shopping season juiced sales. However, it impaired corporate profitability. If profits do not increase, particularly from top line growth, hiring is not likely to increase. One of the reasons (probably the biggest reason) the economy was able to move forward in the face of sequester-related spending cuts and tax increases was that energy prices fell. Falling energy (and food) prices act as a tax cut on consumption. We should all give thanks to a resurgent domestic carbon energy industry for helping the economy overcome Congressional dysfunction.

However, lower energy prices are not a permanent solution to our economic problems. We view the situation as one might view a corporation which reports better earnings due to cost cutting. Yes earnings are better, but gains are limited and finite as costs cannot be cut forever. At some point, costs cannot be cut any further. This is why better corporate earnings due to cost cutting are deemed to be “low quality.”

We view 2013 economic growth similarly. Economic gains were due more to lower costs (energy and food) than to top line revenue growth (job and wage growth). Until household incomes rise steadily, the economy will probably remain in a low gear. As we do not see signs that job and, especially, wage growth are poised to climb dramatically, we do not envision stronger inflation pressures. This should keep long-term rates from rising fast and far. It should also force the Fed to keep policy rates low. As such, we do not see an urgent need to bring portfolio durations in dramatically.

During the past few years, our basic portfolios had a bell-shape to their maturity schedules. As the middle area (belly) of the yield curve offered (in our opinion) the best values on a risk vs. reward basis, we focused portfolios on the belly of the curve. We had been of that opinion ever since the Fed forced long-term yields lower. When long-term rates plummeted, we did not see much value in extending far out on the curve as yields were unattractive versus duration risk. We were not enamored with the short end of the curve either as rates were (and still are) punitive, not keeping up with even the paltry inflation we have seen. We believed a bell-shaped portfolio offered the best compromise between duration risk and return. Although we believed that the so-called “belly” of the curve offered the best values, we would never advocate placing all one’s eggs in one yield curve basket. We placed about half of portfolio holdings on the belly of the curve with the other half of portfolio holdings allocated on inside three years and between ten and twenty years. This is in contrast to the popular barbell strategy which, if constructed following QE∞, left investors with low rates and high duration risk on the long end of the curve and the likelihood of reinvesting short-term holdings at similarly-low rates.

Although times have changed, we still do not advocate a barbell strategy. Instead, our portfolios tend to be more evenly weighted across the yield curve. We still tend not to extend out beyond 20 years and we try to avoid unnecessary holdings inside two years. However, an evenly weighted ladder from two years to ten or fifteen years is probably a good place to start when building a portfolio. Only when we believe that the yield curve will begin to flatten significantly will we shift to a barbell or barbell-like strategy.

By Thomas Byrne – Director of Fixed Income – Investment Consultant

Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.

High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.